Trends in Federal Tax Revenues and Rates

December 2, 2010

Today I testified before the Senate Finance Committee on historical trends in federal tax revenues and rates. My written testimony is a collection of tables and figures with descriptive text (shown below). It addresses three broad topics: revenues collected by the federal government, how taxes affect economic activity, and the tax burden and who bears it.

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Federal Revenues: Trends and Projections

Total federal revenues as a percentage of gross domestic product (GDP) change over time because the size of the tax base for each source changes relative to GDP, because changes in the distribution of income can raise or lower average tax rates, and because changes in tax law affect the amount of revenues collected from a particular tax base. As detailed in the first three exhibits:

  • Over the past 40 years, federal revenues have ranged from nearly 21 percent of GDP in fiscal year 2000 to less than 15 percent in fiscal years 2009 and 2010, averaging 18 percent of GDP over that span. Most of the revenuesabout 82 percent in 2010come from the individual income tax and the payroll taxes used to finance Social Security, Medicare, and the federal unemployment insurance program (see Exhibit 1).
  • Under current law, revenues will rise significantly from their recent low relative to GDP as the economy recovers from the recession and the tax reductions enacted in 2001, 2003, and 2009 expire. We project that under current law, federal revenues will reach 21 percent of GDP in fiscal year 2020, just above their peak share reached 10 years ago (see Exhibit 2).
  • We also project that under current law, federal spending will reach nearly 24 percent in 2020slightly lower than the peak level of almost 25 percent in fiscal year 2009 but well above the average of roughly 21 percent over the past four decades. Compared with that historical experience, the components of federal spending that are projected to be unusually large relative to GDP by 2020 are the expenditures for Social Security and the federal health programs.
  • Even with the projected substantial increase in revenues, under current law deficits between 2015 and 2020 will range between 2.6 percent and 3.0 percent of GDP. If the Congress extended most or all of the 2001 and 2003 tax cuts and made no other changes to taxes and spending, revenues would be lower and deficits would be significantly larger (see Exhibit 3).

How Taxes Affect Economic Activity: Marginal Tax Rates and Tax Expenditures

Taxes raise the price of taxed activities and thereby lower the relative price of other activities. In particular, the income tax and payroll tax reduce the returns from working, and the income tax reduces the returns from saving. One measure of the effect of taxes on the returns from working and saving is the marginal tax ratethat is, the tax paid per dollar of extra earnings or dollar of extra income from savings. Exhibits 4 through 6 present information about marginal tax rates, including the following points:

  • The highest marginal income tax rate (the tax rate that applies to the top tax bracket) was as high as 70 percent as recently as 1980, although a lower maximum rate applied to earnings in that year. Since 1988, the highest marginal income tax rate has ranged from 28 percent to 39.6 percent.
  • For a representative family of four with median income, the marginal tax rate on earnings (combining the rates for both income and payroll taxes) has remained at about 30 percent since the mid-1980s.

Provisions of the tax code can also affect economic activity by subsidizing certain types of spending. Revenues forgone because of certain special features of the tax code are known as tax expenditures. Tax expenditures have helped to accomplish various goals, but because they reduce the base to which tax rates apply, tax rates must be higher to collect the same amount of revenues that would be collected in the absence of those subsidies. Exhibits 7 through 10 present information about tax expenditures, including the following points:

  • The two largest tax expenditures are the deduction of mortgage interest on owner-occupied residences and the exclusion of employers contributions for health care, health insurance premiums, and long-term care insurance premiums from the individual income tax. Each of those results in forgone revenues equal to about 9 percent of individual income tax revenues.
  • There are significant corporate tax expenditures as well.

The Tax Burden and Who Bears It

The final set of charts beginning with Exhibit 11 shows the impact of federal taxes on various categories of households, which bear the economic cost of taxes that they pay directly as well as taxes paid by businesses. One measure of the tax burden is the average tax rate, which equals taxes paid as a share of income. Federal taxes are progressive, meaning that average federal tax rates generally rise with income. Specifically:

  • In 2007, households in the bottom fifth, or quintile, of the income distribution paid about 4 percent of their income in federal taxes, while the middle quintile paid 14 percent, and the highest quintile paid 25 percent.
  • The individual income tax has average tax rates that rise rapidly with income. Payroll taxes have average tax rates that vary little across most income groups but fall for the highest quintile because earnings above a certain threshold are not subject to the Social Security payroll tax and because earnings are a smaller portion of total income for that group. The average social insurance tax rate is higher than the average individual income tax rate for all income groups except the highest quintile.
  • Between 1979 and 2007, the average tax rate for federal taxes declined for all income groups.
  • The share of taxes paid by the top fifth of the population grew sharply between 1979 and 2007. Almost all of that growth can be attributed to an increase in that groups share of before-tax income. In 2007, households in the highest quintile earned 55 percent of before-tax income and paid almost 70 percent of federal taxes; for all other quintiles, the share of federal taxes was less than the share of income.